Liability Driven Investment and Flight Paths Jargon …...4 Schroders Liability Driven Investment...

Liability Driven Investment and Flight Paths Jargon Buster

For professional investors and advisers only

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Liability Driven Investment and Flight Paths Jargon buster

Welcome to the Schroders Jargon Buster

LDI is unfortunately full of confusing and unfamiliar terms. This booklet has identified some of the most commonly used terms that you might come across and attempts to explain what they mean. Hopefully this will enable you to spend more time on making the crucial decisions that will benefit your pension scheme and less time on simply understanding what is being said.

At Schroders we’re keen to support trustees and sponsors on every step of the journey towards providing members with their pension benefits. This Jargon Buster is possibly the first step along that path, if you’d like to discuss the other areas Schroders can support you with please do contact me.

Best wishes,

Stephen Bowles Head of Delegated Sales


Asset swap spread (z-spread)

In the context of LDI this is usually the difference between the yield available on a swap (the swap rate) and the yield on a corresponding UK government bond.

Aa

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Basis

The set of assumptions used by an actuary to calculate the value of a pension scheme’s liabilities. Assumptions include the discount

rate, expected inflation and longevity (how long members are expected to live).

Basis points (‘bps’)

One basis point is equal to one hundredth of one percent (0.01%). i.e. 10 basis points = 0.10%.

Bb


Buy-in

A buy-in is a process by which trustees of a pension scheme purchase an insurance policy to cover a group of their members, for

example, current pensioners already in payment. The trustees hold the policy as an asset and remain responsible for paying the pensions.

Buy-out

A buy-out is where a pension scheme pays a premium to an insurer and in return the insurer takes on all responsibility for

paying the pensions for the scheme’s insured members.

Bb

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BbBuy-out basis (also known as solvency basis)

An estimate of the basis that would be used by an insurance company when taking on a pension scheme’s liabilities. It usually consists of a discount rate based on bond or swap yields. As a result, this usually gives a higher liability value than

the technical provisions, which usually uses a higher discount rate because they assume there will be some investment outperformance during the period in question.


Cashflow Driven Investment (CDI)

Cashflow Driven Investment (CDI) is an investment solution for pension funds which seeks to meet all future liability cashflows with matching payments of

income and redemption proceeds from a wide range of corporate and government bond or bond-like assets with contractual cashflows (see below).

Cc

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CcContractual cashflows

Where there is a legal obligation by a borrower of debt to make one or more defined payments at specific dates.

For example, the cashflows of bonds or bond-like assets used within a CDI solution.


CcCollateralisation

When investing in swaps (and some other LDI assets) a pension scheme is entering into an agreement with an investment bank ‘over-the-counter’ – i.e. entering into an agreement directly with the bank and specific to the particular contract being arranged.

A swap has zero value at the outset of the contract. As market conditions change

the swap becomes an asset to one counterparty and a liability to the other i.e. the swap has a value. The value of the swap at any point in time is known as the ‘mark-to-market’ value.

Given that swap contracts are generally long term in nature, schemes rely on the investment bank being in business at the end of the contract. To mitigate the

risk that the bank becomes unable to meet its obligations under the agreement, swap contracts are ‘collateralised’. This involves the transfer of assets (i.e. collateral) between the two parties with the same mark-to-market value as the swap. In the event of default the party in profit keeps the collateral and retains the benefit accrued on the contract up to that point.

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CcConsumer Price Index (CPI)

An index used to measure price inflation. CPI is similar to the Retail Price Index (RPI), being constructed from the prices of a bundle of goods and services. However due to differences in the way CPI is calculated and some

differences in the basket of goods, CPI has historically been lower than RPI. Therefore schemes that apply CPI rather than RPI for pension increases would expect to have lower liabilities.

Counterparty

The party taking the other side of an LDI contract (such as a swap contract) to the pension scheme. Usually an investment bank.


Counterparty risk

The risk that the counterparty to a contract is unable to fulfil their obligations under the terms of the contract. Counterparty risk can

be managed via collateralisation and appropriate due diligence on prospective counterparties.

Covenant

The financial strength of the employer standing behind the pension scheme. A weak employer is a concern for trustees as the

employer may not be able to afford the contributions required to fund the pension scheme.

Cc

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Coverage (or hedge) ratio

A ratio that compares the sensitivity of a pension scheme’s assets to changes in interest rates and inflation

with the sensitivity of the liabilities to changes in interest rates and inflation.

Cc


Discount rate

Used by the Actuary to place a present value (the value today of a sum of money due or receivable in the future) on a defined benefit pension scheme’s liabilities. For example, if a payment of

£100 is due in one year’s time, then using a discount rate of 5% gives a present value of £100 ÷ (1+5%) = £95.24. The lower the discount rate, the higher the liabilities.

Duration

A measure of the sensitivity of a scheme’s liabilities or LDI assets to changes in interest rates or expected inflation. Duration is measured in years and calculated

as the weighted average time to payment/receipt of the pension benefit payments/asset cash flows. Duration is also equivalent to the % change in value for

each 1% change in interest rates or expected inflation. A higher duration indicates a greater sensitivity to changes in interest rates or expected inflation.

Dd

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EeExpected inflation

An estimate of inflation over the lifetime of a pension scheme. Expected inflation is used by the actuary to estimate the value of a scheme’s pension promises (“liabilities”) that are linked to inflation. The rates implied by

index-linked gilt yields or inflation swap rates (see below) are often used as a starting point. This means that pension scheme liabilities are sensitive to changes in these market rates.


FfFlight Path

A plan that involves adjusting the investments and contributions so that a pension scheme can become “fully funded” or able to reach a position where it can “buy out” (see below) with an

insurance company. Investment risk may be reduced over time in response to increases in the funding level or improved market conditions.

FRS102 (formerly FRS17)

The accounting standard used in the UK that dictates how pension costs appear in company accounts. FRS17, which has been replaced by FRS102, introduced additional disclosure

requirements and the stipulation that liabilities and assets should be valued using market rates. This has increased both the visibility and the volatility of defined benefit pension costs

and has been partly responsible for the closure of many UK pension schemes.

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FfFunding level

The value of a pension scheme’s assets compared to the present value (see below) of its liabilities.

Funding level triggers

Pre-agreed funding levels at which the scheme will de-risk, i.e. reduce the likelihood that funding levels will drop sharply by, for example, switching

growth assets into matching assets such as bonds and/or purchasing additional liability coverage via LDI assets.


Funding level risk

The risk that a scheme’s assets fall relative to its liabilities or that the liabilities increase relative to the assets. A worsening funding level is a concern for trustees as it can lead to increased company

contributions to plug the deficit, or even to members losing benefits if the company becomes insolvent and the scheme is not fully funded.

Ff

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GgGilt repo (repurchase agreement)

Under a repo a pension scheme sells a gilt to an investment bank and agrees to buy it back at a later date at a fixed price. If gilt prices rise during the term of the contract (i.e. if interest rates fall) then the scheme will expect to make a profit. If gilt prices fall (i.e. if interest rates rise) the

scheme will expect to make a loss. These gains and losses are passed to and from the scheme via the process of collateralisation and can be used to offset the rise or fall in the liabilities.

Only part of the cash that the scheme receives from the

initial sale of the gilt under the agreement needs to be set aside to meet potential collateral calls.

The scheme is free to invest the rest of the cash in more gilts to increase interest rate protection further, or in growth assets to increase the expected return.


GgGilt total return swap (TRS)

Gilt TRS’s are similar to interest rate swaps. The scheme agrees to pay a floating rate of interest and receives a fixed rate of interest which is the total return on a particular gilt (rather than a swap rate as in the case of an interest rate swap).

A scheme expects to make a profit under the terms of the contract if interest rates fall. This profit (which is passed to the scheme via the process of collateralisation) can be used to offset the rise in the liabilities, thereby helping to protect the funding level.

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IiIE01

A measure of the amount by which a pension scheme’s liabilities or LDI assets move (their sensitivity) in relation to

changes in inflation. IE01 is the £ change in value for each 0.01% change in inflation.

IAS19 (see also FRS102)

The accounting standard that applies to companies with international operations.

Its principles are similar to those of the UK standard, FRS102.


Inflation swap

Under an inflation swap the scheme makes payments based on expected inflation at the outset of the contract, but receives payments based on actual inflation. The scheme expects to make a profit under the terms of the contract if expected inflation

rises. This profit (which is passed to the scheme on a daily basis via the process of collateralisation) can be used to offset the simultaneous rise in the liabilities, thereby helping to protect the funding level.

Ii

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Interest rates

The most relevant interest rates for pension schemes are those on long-dated government bonds or long-dated interest rate swaps, given the equally long-term nature of pension scheme liabilities. These interest

rates are a key component of the pension scheme’s discount rate (see discount rate above). The nominal interest rate represents the interest rate on fixed-interest gilts and can be used to value pension liabilities

that are fixed in nature. The real interest rate reflects the interest rate earned on inflation-linked investments over and above expected inflation. The real interest rate can be used to value inflation-linked liabilities.

Interest rate swap

Under an interest rate swap one party (in this case the scheme) makes payments based on a floating rate of interest and receives payments based on a

pre-agreed fixed rate of interest. The scheme expects to make a profit under the terms of the contract if interest rates fall. This profit (which is passed to the

scheme on a daily basis via the process of collateralisation) can be used to offset the simultaneous rise in the liabilities, thereby helping to protect the funding level.

Ii


Liabilities

The pension benefits promised by a pension scheme. The present value (see below) of

the liabilities is the discounted value in today’s money of all the promised benefits

Liability Driven Investment (LDI)

The ultimate objective of pension scheme investing is to ensure that there are sufficient funds to pay the liabilities. LDI puts this objective at the heart of a scheme’s investment strategy.

A key aim of LDI is to manage funding level risk (i.e. the variability of the scheme’s assets compared to its liabilities). In practice this usually means purchasing assets, such as bonds, to construct an investment strategy that closely matches the

behaviour of the pension liabilities. These assets are often referred to as ‘LDI assets’ or ‘matching assets’.

Ll

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Longevity risk

The risk that a pension scheme’s pensioners live longer than expected. As a scheme matures, and has a higher proportion of pensioner members, the impact of longevity risk on a scheme increases.

Ll


Market based triggers

These are predetermined market conditions (e.g. interest rates or expected inflation levels) at which the scheme will de-risk.

Mm

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Nominal interest rate

The interest rate on a fixed interest gilt or interest rate swap is known as the nominal interest rate. Nominal interest rates are also used to value fixed liabilities, which can be seen as similar to fixed interest bonds. This is because, like fixed interest bonds, fixed liabilities are a series of predetermined cash flows.

Nn


OoOver-the-counter

Over-the-counter (OTC) derivatives are contracts that are traded and privately negotiated directly between two parties, without going through an exchange or other intermediary.

For example, over-the-counter swap contracts which are negotiated between a pension scheme and an investment bank.

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PpPension Protection Fund (PPF)

A statutory safety net for members of under-funded pension schemes. When the sponsoring employer of a scheme becomes insolvent, its assets and liabilities can be absorbed by the PPF, which then pays a set level of benefits to the members of the

pension scheme. As the assets of pension schemes placed under the control of the PPF are invariably less than the value of the benefits that will be paid, the PPF is “topped up” each year via levy payments from the sponsoring employers of all UK private sector pension schemes.

This includes a “risk-based levy” which varies depending on the expected risk of the employer becoming insolvent. The PPF can therefore be thought of as an insurance fund for pension schemes.


Present value

The present value of a pension scheme’s liabilities is the estimated value in today’s money of all the promised

pension benefits. This is estimated by an Actuary using a discount rate (see Discount rate).

PV01

A measure of the sensitivity of a scheme’s liabilities or LDI assets to changes in interest rates. PV01 is the £ change in value for each

0.01% change in interest rates. Alternatively PV01 = (duration x £value)/10,000.

Pp

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RrReal interest rate

The interest rate earned on an inflation linked investment over and above inflation.

For example, suppose you pay £98 for a one year index linked bond that promises to pay you £100 plus inflation in one year’s time. If inflation over the year is 3%, then at the end of the year you will receive £103. As you paid

£98 for the bond your total return is £103/£98 – 1 = 5%. 3% of this is due to inflation and 2% is due to the real interest rate.It is the real interest rate that determines the price of the index linked bond. So in the example above, a real interest rate of 2% implies that the price of the bond should be £98 (i.e. 2% less than the notional value of £100). As with nominal interest rates, if real

interest rates rise, then the price of the bond falls and if real interest rates fall the price rises. Real interest rates are also used to value inflation linked liabilities, which can be seen as similar to index linked bonds. This is because, like index linked bonds, inflation linked liabilities are a series of cash flows that increase with inflation.

Recovery Plan

The plan outlining how the pension scheme’s sponsoring

employer will meet any deficit through increased contributions.


SsSelf-sufficient

The position when a pension scheme is sufficiently funded to be largely independent of the fortunes of its sponsoring employer. This might mean being fully funded on a buy-out basis, in which case the scheme’s liabilities could

potentially be transferred to an insurance company. It might also mean being fully funded on a basis that uses a gilts or swaps discount rate (which is likely to be close to the buy-out basis). For a pension scheme to be self-sufficient,

investment risk would need to be minimised (e.g. by it only investing in gilts or swaps) as otherwise the sponsoring employer may need to be called upon again to meet deficits that emerge as a result of investment losses.

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SsSwap

A swap is a contract between two counterparties, e.g. a pension scheme and a bank, to exchange a series of cash flows according to a pre-agreed arrangement.

Examples often used in LDI include interest rate swaps, inflation swaps and gilt total return swaps (TRS).

Synthetic bonds

Synthetic bonds seek to replicate the payoff and risk profile of physical bonds using derivatives or other instruments. Synthetic bonds can be used to obtain the matching properties of bonds

without tying up as much capital as with physical assets. The most common types of synthetic bonds are gilt repos and gilt total return swaps.


Technical Provisions (TP)

The statutory measure of a pension scheme’s liabilities used for the triennial actuarial valuation and usually for funding purposes (i.e. working out what, if any, deficit contributions are required from the corporate sponsor – see Recovery Plan).

Tt

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Unwinding effect

As time passes, the moment when benefits start to be paid by the scheme gets closer. This means that the discounting of these payments has a smaller and smaller effect on their value (it “unwinds”). As a consequence, all else being equal, the value of the liabilities increases over time.

This increase is approximately the same as the discount rate used by the actuary. Thus, in the absence of any mitigating factors, the pension scheme’s assets therefore need to outperform this unwinding effect to close the deficit.

Uu


Value at Risk (VaR)

This is a statistical method for estimating the minimum loss that can be expected with a certain level of confidence. Thus a pension scheme could calculate that there is a 95% probability that it will not lose more than 4% of its assets on any given day. The other side of the coin is, of course, that on five days out of 100,

it might lose more than 4%. It is often used as a measure of funding level risk. VaR95, which is commonly used, is the smallest amount by which the funding level is expected to deteriorate if a one-in-twenty year downside event occurs.

Vv

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YyYield curve

The yield curve represents the range of different interest rates (or yields) available on bonds (or swaps) of various term lengths, the period that they remain outstanding before repayment. The yield curve is relevant because often pension scheme benefits due to be paid

at different points in the future will be valued using different interest rates, depending on the time to payment. For example, a benefit payment due in 20 years’ time might be valued using the interest rate on a 20-year interest rate swap.


For more information about investments and other strategies, please contact us.

Tel: +44 (0) 20 7658 4916 Email: stephen.bowles @schroders.com

Stephen Bowles Head of Delegated Sales

mailto:stephen.bowles%20%40schroders.com?subject=

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Important Information: For professional investors and advisers only. This document is not suitable for retail clients. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion.

This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued in March 2019 by Schroder Investment Management Limited, 1 London Wall Place, London EC2Y 5AU. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored. CS1151

Schroder Investment Management Limited1 London Wall Place, London EC2Y 5AU, United KingdomTel: +44 (0) 20 7658 6000 Email: [email protected]

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Liability Driven Investment and Flight Paths Jargon …...4 Schroders Liability Driven Investment...

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